Short-term contracts are viewed as a way of stimulating youth employment. This column presents evidence that this is the case in Spain, but that such contracts are also detrimental to job stability and lifetime earnings. The negative effects get stronger the longer workers are exposed to fixed-term contracts.

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In 2014, youth unemployment rate in the EU stood at 22%, more than double the overall unemployment rate. If it is expensive to fire workers, employers are less willing to take the risk of hiring a young person (OECD 2006). So, should we lower firing costs to reduce youth unemployment in Europe? The Spanish experience shows that such a policy can have very negative effects. In a new paper (Garcia-Perez et al. 2016), we analyse a Spanish labour market reform that lowered firing costs through the liberalization of fixed-term contracts while firing costs were left at higher rates for permanent contracts. Our results show that low skilled youths who entered the labour market after the reform accumulated lower employment and earnings over their career.

Lowering firing costs may improve job access

While firing costs have no impact on the overall level of unemployment (OECD, 2006), making it expensive to fire workers can have adverse effects for young people. Indeed, young people have little or no prior labour market experience, so they are risky hires from the point of view of employers. The “stepping stone hypothesis” says that taking a temporary job can help youths access more stable employment. The empirical evidence for this hypothesis is mixed: some studies find supportive evidence (D’Addio and Rosholm 2005; Booth et al. 2002, Ichino et al. 2008) while some others do not (Zijl et al. 2004, Autor and Houseman 2010).

Fixed-term contracts are one particular form of temporary work. These contracts allow employers to specify a contract duration after which the worker can be let go at low cost. By contrast, permanent contracts have an indefinite duration, and firing workers is typically more and more expensive as the worker accumulates tenure with the employer. Fixed-term contracts have become very popular with employers in many European countries, and especially in Spain, where the share of fixed-term contracts is currently above 50% for young workers, and 94% of all new signed contracts are fixed-term.

Spain is an interesting case because it liberalized the use of fixed-term contracts for essentially all job types as early as 1984. Fixed-term contracts were an instant hit with employers and the growth of this type of contract was particularly high for young workers. In our paper, we investigate the impact of the introduction of this reform on the careers of male high-school drop-outs. We focus on males because they have fewer employment interruptions and on high-school drop-outs because low skilled workers are believed to be most adversely impacted by high firing costs.

Our hypothesis is that having the first employment experience in a labour market with light regulation on the use of fixed-term contracts can have a long-term impact on one’s future employment career. Thus, our strategy is a cohort regression discontinuity. Essentially, we compare youths who turned 16 and thus could work in the quarter after the reform was introduced (third quarter of 1984), with youth who turned 16 in the quarter before the reform was introduced (second quarter of 1984). Therefore, we compare the labour market career of two cohorts of workers that are exposed to the same labour market conditions during most of the years with the (only) difference being that one entered the labour market under a tight regulation of fixed-term contracts while the other entered when the use of temporary contracts was liberalized. We find that the liberalization of fixed-term contracts in Spain increased the probability that a male high school dropout would have a first job before age 19. This is consistent with the stepping stone hypothesis. But does this mean that young people are better off with the wide availability of fixed term contracts?

In the long run, fixed-term contracts reduce employment and earnings

The danger of fixed-term contracts is that young workers can go from fixed-term contract to fixed-term contract, leading to lower employment stability and no progression towards better jobs (Blanchard and Landier 2002). Social security data allows us to follow youths who entered the labour market around the time of the Spanish liberalization of fixed-term contracts for more than 20 years.

We compare the cohort of male high-school dropouts who could enter the labour market in the quarter before the liberalization of fixed-term contracts (second quarter of 1984) with those who could only enter after the reform (third quarter of 1984). Figure 1 shows the annual number of days worked (on average during the first ten years in the labour market) for each cohort born in the quarters between 1965 quarter 1 and 1972 quarter 4. In Figure 1 we can see that the employment levels for these two cohorts were very different: the cohort of young people who were exposed to fixed term contracts was working significantly less during the first ten years in the labour market than the cohort that preceded it. These are two cohorts of people born only one quarter apart, yet their employment outcomes are starkly different. This illustrates the adverse impact of fixed-term contracts on employment. For male high-school dropouts, fixed-term contracts led to a 4.5% reduction in days of employment over the first ten years in the labour market.

Figure 1. Annual number of days worked by male high school drop-outs in the first ten years in the labour market

In terms of earnings, the impact of the liberalization of fixed term contracts is even starker, as shown in Figure 2. The reform led to a 9% decrease in earnings for male high-school drop-outs during their first ten years in the labour market. This negative effect is even greater than the employment effect, which means that workers are earning less for each day worked after the introduction of fixed-term contracts. In other terms, fixed-term contracts not only decrease employment, they also reduce workers’ wages conditional on working! This result is consistent with Blanchard and Landier’s (2002) theoretical model showing that the availability of fixed-term contracts encourages employers to create low productivity and hence low pay jobs.

Figure 2. Logarithm of yearly earnings for male high school drop-outs in the first ten years in the labour market

The adverse impact of fixed-term contracts on employment and earnings is incredibly persistent over the career of these low-skilled males. While the impact beyond the first ten years is less, it is still negative and statistically significant. Over 27 years, fixed-term contracts lead to a 7.5% reduction in earnings.

There are reasons to believe that the negative impacts of fixed-term contracts are even larger than what we estimated here.

First, we are comparing two cohorts of workers whose exposure to fixed-term contracts only differ in their first quarter in the labour market.

Beyond the first quarter, both cohorts were exposed to widely available fixed-term contracts. It is likely that the effect would be more negative if the pre-reform cohort was grandfathered in and never exposed to fixed-term contracts.

Second, the negative impacts of fixed-term contracts is larger than what we estimate by comparing our two key cohorts is given by looking at Figure 1 and Figure 2 above.

With our strategy (regression discontinuity) we are only estimating the impact on the first affected cohort. However, after the first cohort exposed to fixed-term contracts, each subsequent cohort experienced progressively worse labour market outcomes. Because fixed-term contracts were ramped up over time, some of this worsening of labour market outcomes is likely due to the wider and wider use of fixed-term contracts.

Conclusions: Fixed-term contracts – a stumbling block for the careers of low-skilled youths

By making it less risky to hire workers, fixed-term contracts should help youths find a first job. And indeed we find evidence for this mechanism in the Spanish experience. Yet, over the first ten years in the labour market, fixed-term contracts lead to 4.5% lower employment and 9% lower earnings for male high-school dropouts. Therefore, when taking the long view, fixed-term contracts are not a stepping stone but rather a stumbling block for the careers of low skilled youths.

Ichino, A., Mealli, F. and Nannicini, T. (2008): From temporary help jobs to permanent employment: what can we learn from matching estimators and their sensitivity?. Journal of Applied. Econometrics., 23: 305–327. doi: 10.1002/jae.998.